Groceries Are A Rotten Business

Supermarket giants Albertsons and Safeway (NYSE:SWY) made news last week by agreeing to merge, creating a combined company that will fall just shy of Kroger (NYSE:KR) in terms of store count. Cerberus Capital, the private equity firm that owns Albertsons, has offered to pay $40 per share for Safeway.

But naturally, whenever a large merger like this is announced, it raises questions. I have two particular questions at the front of my mind: Will there be more industry consolidation to come? And more importantly, who are the winners and losers?

A Brutal Industry

The biggest winners in the Albertsons-Safeway merger are, of course, the Safeway shareholders. Belief that a buyout was imminent was a major factor in Safeway's share price rising about 20% year-to-date.

Given the size of the remaining players, large consolidation is unlikely, though given the competitive dynamics of the business, it would be welcome.

Company

Ticker

# Stores

Revenues

ROA

ROE

Market Cap

P/E TTM

Wal-Mart

WMT

4,005

$470 billion

8.73%

23.62%

$242 billion

15.36

Kroger

KR

2,424

$98 billion

6.31%

31.87%

$22 billion

15.02

Safeway

SWY

1,418

$36 billion

2.55%

5.61%

$8.8 billion

2.86

SuperValu

SVU

2,398

$17 billion

3.12%

N/A

$1.7 billion

N/A

Whole Foods

WFM

360

$13 billion

10.6%

15.0%

$20.2 billion

36.17

Amazon.com

AMZN

N/A

$74 billion

1.2%

3.1%

$169 billion

621.36

The mass-market grocery store space has been saturated for years. Kroger currently is the second-largest grocery chain in the United States after Wal-Mart (NYSE:WMT), though it, of course, sells much more than groceries.

Outside of premium or specialty grocers - think Whole Foods (NASDAQ:WFM) or Trader Joe's - growth in grocery sales is essentially limited to population growth, which has averaged less than 1% for the past decade. All jokes about Americans getting fatter aside, we're really not eating more, and the grocery business is something of a zero-sum game for existing competitors. Again, outside of specialty or premium stores, new grocery store construction is mostly limited to new neighborhood construction.

This is reflected in profitability, measured here by return on assets (I used return on assets over the more commonly used return on equity, because it is less sensitive to differences in capital structure, i.e. debt level).

Safeway's return on assets shot up last year due to one-off asset sales, but over the past two decades, the company has struggled to generate returns much better than 5%. The same is true of Kroger.

Wal-Mart, aided by its scale and ruthless efficiency, has been consistently more profitable, though Whole Foods has recently taken the lead.

Safeway's merger with Albertsons should improve its competitive prospects, as the larger economies of scale and bargaining power with food manufacturers should allow the company to squeeze out slightly higher margins. But it's worth noting that so far, over time, Kroger has had roughly similar levels of profitability as Safeway. (The spike in Safeway's RoA was in part due to divesting Canadian stores.)

As with the rest of American retail, there are two models to higher profitability in the grocery business:

Compete on cost

Go upscale and compete on quality

You're not going to beat Wal-Mart on cost. Some smaller, niche stores - such as Aldi - can be competitive with WMT on price, though they generally lack its brand selection and variety. Kroger can't beat Wal-Mart on price, and it's hard to see Albertsons-Safeway being any more effective.

Going upscale is an option, of course. Even WMT offers a limited selection of organic and premium produce, and offering a wider selection might make it less worthwhile for a neighborhood shopper to drive across town to a Whole Foods or Trader Joe's store. But transformations like that are not particularly easy to pull off.

A more likely scenario is that Albertsons-Safeway finds itself, like Kroger, a lower-margin also-ran that is "stuck in the middle" between low cost and higher quality.

Aisle 5 Is Now Online

Then, of course, there is the elephant in the room: online grocery shopping.

Something sends a chill down the spine of a traditional retailer hearing the name "Amazon (NASDAQ:AMZN)." Amazon has taken a wrecking ball to every market it has entered, essentially putting Borders out of business and giving Best Buy (NYSE:BBY) a thorough beating.

Well, Amazon also has joined the grocery fray as well via its Amazon Food site, which sells packaged foods, and its newer Amazon Fresh, which offers fresh produce delivered to your door in a limited number of markets. AMZN encourages a subscription model, whereby shoppers get certain common items - say, a two-liter bottle of Coke - delivered at a regular interval.

Not to be outdone, Wal-Mart has jumped into online groceries as well. In addition to offering free home delivery on orders $50 and up (Amazon offers free delivery on orders $35 and up), WMT has the added bonus of offering free in-store pickup at its massive network of stores. Wal-Mart does not deliver perishables or fresh produce - yet. But you can bet that it's studying Amazon's moves closely.

Albertsons, Safeway and Kroger all also offer some limited form of online shopping or delivery, though it varies by geography.

Online groceries were an unmitigated disaster when the concept was first tried in the late 1990s. Remember HomeGrocer.com and Webvan? You probably don't, and there is a reason for that. Neither survived the 2000-02 shakeout. It was a business model ahead of its time.

Granted, Americans are a lot more web-savvy than they were 10 years ago, and have grown more accustomed to paying for delivery. And AMZN and WMT are established retail empires with massive infrastructure in place, not fledgling start-ups.

Still, outside of major urban areas with high population density - think New York or San Francisco - or among high-income Americans that are insensitive to price, we're probably at least five to 10 years away from home grocery delivery being mainstream.

Why? Because groceries, again, are a low-margin business, and delivery operations are expensive to maintain - particularly in cities with sprawling suburbs like Los Angeles, Houston, or Dallas.

There Are Winners… Just Not Traditional Grocers

So, in the meantime, where are the pockets of opportunity in grocery stocks?

As a business, I consider Whole Foods to have the best prospects of the lot and best potential for growth. But WFM is only slightly more profitable than Wal-Mart, and sports a frothy P/E ratio that is more than double the industry average. I love Whole Foods as a company. But I can't get comfortable with the exorbitant price of WFM stock.

I would argue the same for Amazon. Amazon is an amazing company, and Jeff Bezos is a CEO that I respect. But Bezos' focus on revenue growth at the expense of all else has left the company barely profitable, and it sports the lowest return on assets in the sector. Also, AMZN stock is more than four times as expensive as WMT on a price/sales basis (2.28 vs. 0.51, respectively).

If I'm buying any grocer, it's going to be Wal-Mart. It has a scale that none of its competitors can match, has the highest profitability of the mass-market grocers, and offers a very reasonable valuation at 15 times trailing earnings and 13 times forward earnings. WMT has also been aggressively shrinking its share count and raising its dividend.

And before you write Wal-Mart off as a retail dinosaur, consider that WMT has a division situated in the center of Silicon Valley - Wal-Mart e-commerce - that is staffed with 1,500 techies whose job is to find ways to fight Amazon on its own turf.

Will Wal-Mart catch up to Amazon in terms of sales growth any time soon? No, not realistically. But it also has a massive international logistical operation in place that Amazon is still trying to build. And frankly, no one on Wall Street expects much from WMT these days, so any surprise in performance is likely to send the shares sharply higher.

As for traditional grocery stores, I would stay out of this space. Realistically, they cannot compete with the likes of Wal-Mart or Amazon, and they lack the scale to make home delivery work. I'm not forecasting a wave of bankruptcies any time soon, but not much in the way of profitability either.

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